Loonie Falters on Volatile Commodity Prices

In its last statement, the Bank of Canada advised that an interest rate hike later this year was likely, but this may now be on hold given the recent turn of events. Indeed, some quarters are even suggesting that the Bank of Canada may be forced to lower rates, although this seems like a long shot.

The ongoing market turmoil has wiped out billions in market valuations in less than a week. Also caught up in the wake of the sell-off has been the Canadian dollar. How bad has it been for the loonie? Since the end of July the loonie has lost five per cent to the U.S. buck and is now trading at just slightly more than one cent above parity. Investors are understandably concerned that the loonie could lose even more ground to its U.S. counterpart.

The Canadian economy -- and by extension the loonie itself -- is closely tied to demand for the commodities Canada exports. Canada is the largest supplier of crude oil to the U.S. and also sends many other resources and manufactured goods to the American market. A full 75 per cent of Canada's exports are shipped south to the U.S. which means that even a modest slowdown in the U.S. can have a significant impact on Canadian growth.

Canadian Dollar Outlook

Canada's trade deficit increased to $1.6 billion in June from an even $1.0 billion in May. Much of this can be traced to declining demand in the U.S. for Canadian goods and the revised outlook for the U.S. provides little optimism for improvement.

On Tuesday, the Federal Open Market Committee downgraded its assessment noting that "downside risks to the economic outlook have increased." The FOMC statement also went on to say that it now expects "a somewhat slower pace of recovery over coming quarters".

In light of the lowered growth outlook, the Fed committed to maintaining the current ultra-low interest rate until at least the middle of 2013. This pessimistic outlook on the state of the U.S. recovery may force the Bank of Canada to reassess its own interest rate policy.

In its last statement, the Bank of Canada advised that an interest rate hike later this year was likely, but this may now be on hold given the recent turn of events. Indeed, some quarters are even suggesting that the Bank of Canada may be forced to lower rates but unless the economy slows dramatically, this seems like a long shot.

The prevailing thought is that the Canadian economy is still well-positioned to grow at a healthy pace even if at a slower rate than previously expected. While this may not be enough to see the Canadian dollar reach the levels earlier this summer, the loonie should still find sufficient support to maintain current exchange rate levels.